1. Field of Invention
Aspects of the present inventions relate to methods and systems useful for electronic brokerage services and, more particularly, to methods and systems for providing an electronic market for futures contracts and associated instruments.
2. Discussion of Related Art
Buyers and sellers of various financial instruments currently transact business within a variety of established markets. Some of these established markets are over the counter markets that operate using voice or electronic communication among trading desks, some are traditional, brick and mortar exchanges with a trading floor, and others are virtual, electronic exchanges.
A particular example of an over the counter market is the current market for credit default swaps (CDSs) and other related instruments such as fixed recovery CDS and recovery locks (also referred to as recovery default swaps (RDS)). A credit default swap is a contract between a buyer and a seller which shifts the financial risk that a reference entity may experience a credit default event from the buyer to the seller. In exchange for assuming this risk, the seller receives some form of consideration from the buyer, such as periodic cash payments or the combination of an upfront cash payment and standardized periodic cash payments. In addition to the default risk, the seller of CDS also has exposure to the recovery rate of the underlying bond since the loss on default will depend on the amount recovered for the bond. Fixed recovery CDS shift some of this risk back to the buyer of the CDS as they function exactly like ordinary CDS with the exception of having a fixed recovery rate that is a pre-specified percent of notional negotiated by the counterparties at inception. The seller's obligation in a CDS, whether it is a regular CDS or a fixed recovery CDS, is triggered if the reference entity defaults on a credit obligation, such as by entering bankruptcy.
A recovery lock is an over-the-counter instrument that allows traders to lock-in or speculate on the recovery rate on the obligations of a corporation or government entity upon the occurrence of a credit event. Upon the occurrence of a credit event, either the buyer or the seller will have an obligation to pay its counterparty, depending on the difference between the realized and fixed recovery rate. Typically, recovery locks are structured such that no consideration is paid by either party at any point during the term of the contract if the reference entity does not experience a credit event.
Along with the three above mentioned over the counter credit derivatives that consist the foundation of the over the counter credit derivatives market, this market includes many other financial instruments. Thus, the current over the counter credit derivatives market provides sundry instruments for executing financial tactics such as hedging and speculation.
Public markets also offer similar instruments or have attempted to do so in the past. In particular, these products include the CME credit event futures, the CBOE credit event binary option and the Eurex credit futures. The CME credit event futures are not currently offered for trading. They were futures contracts that allowed the transfer of credit risk from buyer to seller on a futures exchange without any consideration transferred from buyer to seller at the outset of the trade. The gain or loss was made based on the starting and final settlement price of the futures contract, which was a function of both the state of the reference entity and the recovery rate on the debt of the underlying reference entity. The CBOE credit event binary options are option contracts that allow buyers to obtain protection in the event of a default by the reference entity or defaults by a basket of reference entities in exchange for the upfront payment of a premium. Upon the occurrence of one or more defaults, the contracts are automatically exercised and provide a pre-determined cash payoff to the buyer. Similar options are also offered on a basket of reference entities, with payoffs occurring either upon each occurrence or at expiration based on the default history of the basket of reference entities. Lastly, the credit futures traded on the Eurex are index futures linked to iTraxx®. The final settlement value of these contracts are determined by the number of names contained in the index, the default status of the reference entities are determined by the ISDA® rules and the ISDA® committee.
Together, these contracts provide some publically traded instruments to move credit risk among participants on an exchange facility.
There are related markets for the transfer of natural catastrophe risk, where the final value of the instrument or the payoff in the case of an option structure depend on the occurrence of natural catastrophes such as hurricanes, earth quakes and floods. Examples of such markets include the over the counter markets for insurance or reinsurance swaps, catastrophe bonds (CAT bonds) and industry loss warrants (ILWs) and the traditional electronic market for insurance futures.
The over the counter markets for insurance or reinsurance swaps, CAT bonds and ILWs function like the market for CDS and related products. Insurance or reinsurance swaps are contracts between a buyer and a seller that shift the financial risk from the buyer to the seller in the event of the occurrence of a natural catastrophe, as defined in the contract. In some cases, the mere occurrence of the event is not the trigger, but rather payment from the seller to the buyer may depend on the losses incurred as a result of the event breaching a certain threshold. In exchange for assuming this risk, the seller receives some form of consideration from the buyer, such as periodic cash payments. Catastrophe bonds are financial instruments where a buyer of the bond, an investor, lends funds to the seller, typically an insurance company, in exchange for periodic interest payments. In the event of a default and, in some cases in the event that the losses realized by the seller meets certain criteria such as exceeding a threshold, the seller only returns a portion of the principal, if any remains after the amount defined in the debenture is retained. CAT bonds are also traded in the secondary market after they are issued. ILWs are options on natural disasters. In exchange for a premium, a buyer receives the right to a pre-defined payoff in the event that a natural disaster causes a pre-specified amount of industry loss. There are many variations on the exact terms and triggers of these over the counter insurance products that allow market participant to receive tailored or generic hedges and to speculate on events.
Insurance futures are traded on exchanges such as the Insurance Futures Exchange, and have a binary settlement value determined by the occurrence of a natural catastrophe. The final settlement value may also depend on the level of industry losses caused by the natural catastrophe. For example, the Florida Hurricane contracts traded on the Insurance Futures Exchange settle at 100, in the event of a Florida hurricane causing more than $US 20 Billion in industry losses. Otherwise, if either no events occur or if the event does not cause more than $US 20 Billion in industry losses, the contract settles at 0.